The First Step in Restructuring the US Electric Industry

Abstract.The electric industry lobbied for its first
step in restructuring, from local franchises to regulated state monopolies
during the early 1900s.The present
paper examines this restructuring with an empirical model that includes the introduction
of natural gas and steam turbine generators.The restructuring resulted in fewer firms, higher costs, and higher
prices, consistent with increased monopoly power and captured regulators.

Introduction

Electric industry
restructuring is underway, if with halts and sputters.There is interstate wholesale competition and
tentative steps toward retail competition.Congress has introduced national bills and the Clinton administration had a
tentative proposal, but the Bush administration has taken no steps.As restructuring evolves, disagreement over
its virtues are bound to persist.Several studies speculate about how a “deregulated” market might
function, some pointing to market complexities that raise doubts about applying
straightforward economics principles.Restructuring is an economic, legal, and political issue.

There is perspective
gained by looking back at the first restructuring of the industry, a move from
its early days of local competition to regulated state monopolies.In its infancy, the US electric industry was
a collection of competitive local franchises.Shortly after the turn of the 20th century and following
industry lobbying, individual states began to establish regulated
monopolies.By the 1930s, the industry
was transformed.The present paper uses
an empirical model to assess the impact of this restructuring on industry
conduct and performance.

1.A Competitive Electric Industry

Commercial generation
began in 1882 with plants opening in New York City and Wisconsin. By 1890, there were a thousand generating
facilities producing direct current (DC).The cost of transmitting DC much beyond a mile was prohibitive, limiting
the geographic area served by a single generator.

During the late 1800s,
alternating current (AC) was widely used in Europe but special interest
groups slowed its adoption in the US.A prominent member of these groups was Thomas
Edison, owner of many DC stations.The
electric chair used AC and one argument of the DC lobby was that the “deadly
current” should not run through the walls of a house.Nevertheless, George Westinghouse
demonstrated the advantages of AC with a system that transmitted electricity
for several miles and by the turn of the century AC was the dominant power
according to Hunter and Bryant (1991).

In the early 1900s,
there was loose regulation and electric firms paid local governments a typical
franchise fee of 5% of revenue.Franchises were generally nonexclusive and many cities had multiple
providers.As an example, Denver granted “general
electric franchise to all comers” short of obstructing public
thoroughfares.Behling
(1938) notes that New York City had 6 electric
companies in 1887 and Chicago had 45 in 1907.As cities and industry grew, electric firms became an important source
of local government revenue.Multiple
local franchises were a conscious policy to regulate through competition as
pointed out by Glaeser (1957).

Since each city had an
independent franchising authority, electric firms trying to expand their areas
found multiple negotiations and differing fees both costly and burdensome.As relief, the industry led by Samuel Insull of Chicago Commonwealth Edison advocated state
regulation.McDonald (1962) points out
that Insull led members of the National Electric
Light Association, later Edison Electric Institute, in a call for state
regulation.

The first state to
implement a public service commission (PSC) was Massachusetts in 1889, followed by Virginia in 1902.By 1912, there were 18 states with PSCs.The number of PSCs then increased dramatically, reaching 38 by 1922 and
becoming almost universal by the 1930s as summarized in Table 1.

Table 1.Dates of State Regulatory Commissions

YearState

1889MA

1902VA

1907NY WI

1908VT

1909MI

1910MD

1911CA CT KS NH NJ NV OH OR WA

1912AZ RI

1913CO HI ID IL IN MO MT NC OK WV

1914ME
PA

1915AL
SC WY

1917UT

1919ND
TN

1920GA

1921LA

1934KY

1935AR

1941NM

1949DE

1951FL

1956AK
MS

1972NE

1975SD MN TX

Source: NARUC
Yearbook of Regulatory Agencies 1991-1992

PSCs regulated prices
within state boundaries but Clemens (1950) points to the interstate pricing
issue made clear by the Attleboro case of 1927.Narragensett
Electric in Rhode Island sold a small amount of
electricity to Attleboro Steam and Electric in Massachusetts.The Rhode Island Commission considered the
low rate a burden on Rhode Island consumers and ordered
a higher rate.Misery loves
company.The Supreme Court, however,
ruled that the mandated rate placed an unconstitutional burden on interstate
commerce.The US Congress subsequently
amended the 1920 Federal Water Power Act with the Federal Power Act of 1935
granting the Federal Power Commission jurisdiction over interstate wholesale
rates.

2.Restructuring, 1907-1932

Table 2 presents some
historical data, including the real price of electricity Pe
calculated as average revenue per kilowatt hour (kWh) in 1932 dollars.The raw data from the Census of the Electric Power and Light Industry includes industry
total revenue TR, quantity of output Q, the number of firms F, and the
horsepower of different types of generation.The price dropped dramatically between 1907 and 1917. By 1927, however, 34 states had regulated
monopolies and the price of electricity began to rise. Similarly, the number of
firms peaked in 1917 but with the increased prevalence of state regulation
declined 48% by 1932.Output increased
during this period, more than doubling from 1912 to 1917 and again from 1922 to
1927, as the number of customers grew exponentially.

Table 2.Evolution
of the Early Electric Industry

1907
19121917192219271932

electricity price, Pe$0.45$0.39$0.22$0.21$0.20$0.27

number of firms,N471452216542635543353429

millionsmWh, Q61022336880

% generation steam, G20%38%48%58%59%68%

Source: Census of the Electric Power and Light Industry

With improved
technology and new steam turbines, electricity output per worker rose.The four main sources of power were
combustion engines, steam engines, steam turbines, and hydroelectric
generation.The new technology utilizing
steam turbines supplied 20% of horsepower in 1907 but by 1932 that percentage
had more than tripled.The share of
hydroelectric power remained stable over the period.

Between 1911 and 1920,
most states replaced local franchises with state regulated monopolies, a shift
from locally governed competition to state regulated monopoly.After 1920, industry output continued to grow
but the number of firms decreased, and after 1927 the real price of electricity
rose.

Stigler and Friedland (S&F, 1962) study the period before the Federal
Power Act of 1935 and examine the effect of regulation on electricity prices,
differential pricing across customer classes, and prices of electricity
stocks.They conclude that regulation
had no effect on electricity prices in 1922.Comanor (1970) and DeAlessi
(1974) point out that under the appropriate one tailed test the S&F
regulation coefficient is significant at the 10% level, suggesting the opposite
conclusion.

S&F examine the
ratio of residential to industrial prices and predict that regulators would
cater to the popularity of cross-subsidized or relatively low rates for
residential consumers.They uncover
evidence of the opposite for both 1917 and 1937.The ratio of residential to industrial prices
was higher in the regulated states.They
conclude that regulation had no effect but might have concluded that industrial
lobbies had more influence on the PSCs than
residential groups.

Jarrell (1978) modifies
the S&F analysis by separating “early” states that established commissions
between 1912 and 1917.Jarrell finds
early states had lower prices and highest outputs, and concludes that the
competition induced by local franchises induced producers to lobby for state
monopoly regulation.

Jackson (1969) uses 1917-1950
data to estimate the more recent impacts of regulation, and concludes that
regulation lowered the relative residential price using a specification similar
to S&F.Moore (1970, 1975) finds
that state regulation resulted in a higher ratio during the 1950s and
1960s.The conclusion is that influence
of large industrial buyers on state PSCs solidified
by the 1950s.

3.Incentives and Local Franchises

The move to state
regulation reduced regulatory negotiations, increased information asymmetries
with regulators, and dispersed the effects of regulation.State monopolies ended franchise fees for
local governments, and the public paid costs of the PSCs.Of the 40 states with PSCs
in 1941, only 23 had a provision for the utilities to pay regulatory commission
expenses (StateCommission Jurisdiction, 1941).

The principal-agent
problem underlies another motive for the industry to advocate state regulation
as developed by Barnett and Sophocles (1997).A regulated industry has incentive to distance itself from its regulator.Local nonexclusive franchises would seem
likely to keep price closer to the competitive level.Kaserman and Mayo
(1995) point out that state regulation involves an elected official, a
legislative committee, and a regulatory commission staff.With this increase in the number of
principal-agent relationships, there is more opportunity for agents to
substitute their own agendas for those of customers.In contrast, local franchises would make
customer wishes more prominent.

By expanding the scope
of regulation from the local to the state level, the industry dispersed the
effects of regulation over more customers.This larger and more diverse customer base made it more difficult for
customers to organize politically in opposition to regulatory rulings.This, in turn, gave both regulators and
regulated firms more discretion.Similarly, Peltzman (1976) makes the point
that the electric industry would now prefer federal to state regulation.

4.Restructuring I: An Empirical Multi-Market Model

At the turn of the
century, natural gas was a final product, providing lighting and a general
substitute for electricity.Natural gas
was also an input in electricity generation.The input of gas in electricity generation increased dramatically during
this transition: 1.3 billion cubic feet in 1907, 20 billion in 1922, and 96
billion in 1932.Further, by 1932 steam
turbines generated over 60% of all electricity.

The following
multi-market system of stochastic equations captures these market
interdependencies.Two stage least
squares estimates on the pooled data yield consistent unbiased estimators:

The quantities of electricity
demanded and supplied equal the quantity of output in market equilibrium, De
= Se = Qe.Price Pe
is average revenue per kWh, reported in the data for 1927 and 1932 and
calculated consistently for previous years.To the extent that electricity was a substitute for gas in consumption,
the relationship between its price Pg and the quantity of
electricity demanded D would be positive in (1).Aggregate income Y, the manufacturing wage
bill by proxy, should increase demand if electricity is a normal good.Industrial demand for electricity,
represented by manufacturing value added V, would also raise demand.Population N should increase demand, as
should time T with the introduction of electric appliances during the period.

On the supply side, a
higher price for the inputs of gas Pg, coal Pc, and oil
input Po should raise cost and reduce electricity
supply S in (2).The effect of the
number of electric firms F on quantity supplied would depend on output per
firm.Variables on the percentage of steam
generation G and hydroelectric generation H in (2) capture the introduction of
these technologies.

The number of firms F
is the endogenous variable in (3).Electric industry profit should lead to entry, and industry revenue E is
a proxy for profit.State PSC regulation
R is an exogenous political variable in the model that imposes entry barriers
and should reduce the number of firms F.

Data for natural gas
are from Mineral Resources of the United
States.A system of pipelines
developed during the period from the major producing states:Pennsylvania, West Virginia, Ohio, Texas, and Oklahoma.In some states such as California, consumption equaled
production.For states without
production, there is no reported price but the average price of neighboring
states is a proxy for the price of gas.For example, Mississippi reported no production
or consumption in 1907 but Louisiana, Arkansas, Tennessee, and Alabama produced gas that was
in principle available in Mississippi for no less than some
average of these neighboring prices plus a transmission cost.A similar procedure calculates a price for
coal Pc and oil Po in states without
production.

The manufacturing wage
bill Y is from Earnings of Factory
Workers and the Statistical Abstract
after 1929.Manufacturing value added V
and total state population N are also from the Statistical Abstract.

Dates of state PSC
regulation from the NARUC Yearbook differ
in a few cases from Stigler-Friedland (1962) and
Jarrell (1978).Both S&F and Jarrell
assume regulation was effective three years following a PSC but they typically
began after years of judicial debate.S&F use 1914 as the first year for a state commission in Virginia but there had been a
state commission since 1902.Legislation
creating an Illinois PSC passed in 1907 but implementation did not take place
until 1913.Municipalities did not idly
lose a major source of revenue.Shortly
following establishment of the PSC in Illinois, municipal governments
started the “Home Rule” movement to regain their lost local franchises as
reviewed by Hughes (1983).Given the
high political profile of restructuring, the present study uses no time lag for
the state regulation variable R.

5.Empirical Results of the Multi-Market Model

Table 3 presents the
model estimates.The demand for
electricity D in (1) is price inelastic, suggesting regulatory constraints were
binding.The price and quantity demanded
rose over the estimation period but control variables should adjust for
increased demand.Without binding
regulation the state monopolies would have charged higher prices, but the
regulated price might have been higher than it would have been with competitive
local franchises.

Table
3.Multimarket
System, 1907-1932 (t-statistics)

(1)(2)(3)(4)(5)

lnDlnSlnFlnDglnSg

lnP-0.923-4.3793.046

(-8.77)(-8.49)(4.39)

lnY0.218-1.756

(4.89)(-1.36)

lnPg-0.1490.583-15.3712.36

(-0.88)(0.54)(-3.14)(-2.83)

lnPc-0.520

(-0.82)

lnPo-0.836

(-2.03)

lnV0.3212.135

(7.74)(1.78)

lnF0.008

(2.53)

lnN0.2237.185

(3.79)(4.22)

T0.0750.462

(15.8)(3.36)

G0.154

(0.64)

H-3.542

(-5.09)

E
36.4

(3.32)

R-60.3

(-2.20)

Higher income Y
increased demand, indicating electricity was a normal good.The price of gas Pg did not affect
demand, suggesting electricity was not an effective substitute for gas in
consumption.Manufacturing output V had
a positive effect on demand. Population
N and time T increased demand.

On the supply side in
(2), the price of electricity Pe had a
negative effect on quantity supplied.The trend toward regulated state monopolies during the period evidently
undermined the economic relationship between price and output.

Electric industry
revenue E had a positive effect on the number of firms F in (3).Revenue E is a proxy for profit, and higher
profit would attract firms to the industry.State PSC regulation R lowered the number of firms, most likely
promoting consolidation or mergers as it inhibited competition.

Regarding the demand
for natural gas DG in (4), the price of electricity Pe had a positive impact.Even though electricity was not a substitute
for gas in consumption, gas was a substitute for electricity.Consumers were sensitive to the price of
electricity, at the time newer and relatively expensive.The coefficient on the price of gas Pg
in (4) indicates highly price elastic demand.Higher income Y lowers demand for gas suggesting it was an inferior good
(a marginally insignificant effect).The
demand for gas increased with both population N and time T.The price of gas Pg had a negative
effect on the quantity of gas supplied Sg
in (5) due in part to the states reporting no production and the imputed
positive price.

Previous studies have
reported inconclusive evidence on the effect of state regulation on the price
of electricity.Price was falling during
the early period but the decline stopped at about the time a substantial number
of states had regulatory commissions.Increased regulation lowered the number of firms, reducing supply.Solving (1) and (2) in Table 3 for lnP, the elasticity of price with respect to the number of
firms is dlnPe/dlnF = -0.002.Given dlnF/dR = -60.3 from (3), it
follows that dlnPe/dR = .061.State PSC regulation led to a higher price of
electricity.

It is possible to
calculate the entire set of price elasticities in a similar
fashion.In equilibrium, lnD = lnS in (1) and (2).Dropping insignificant coefficients and
solving for lnPe,

Every 1% increase in the price of gas Pg
raised the price of electricity by only 0.173%.Elasticities of price Pe
with respect to income Y, manufacturing value added V, number of firms F, and
population N are very small.

6.The Effects of Restructuring on Cost and
Profit

The present section
examines the effect of regulation on cost and profit using data from 1907 to
1922.After 1922, the Department of
Census quit reporting “expenses” perhaps due to pressure from the evolving
monopolies.There might have been an
assumption that revenue and cost would be equal for rate-of-return regulated
firms.Of the 40 states that had
regulated monopolies by 1932, all but two had made the transition by 1922.

Let Ce
represent the average cost (price) of producing one kWh of electricity,
calculated as total expenses divided by output.Average output per firm is q.Table 4 presents an estimate of the cost function at the firm level,

An increase in the
price of gas Pg raises cost Ce,
while prices of coal Pc and oil Po have no effect.Cost Ce
declines with output per firm q, evidence of decreasing cost at the firm
level.

A higher percentage of
hydro production H lowers cost Ce.Its positive effect on price in (2) suggests
that regulated monopolies enjoyed lower costs but charged higher prices when
they moved to hydro generation.Regulation R raises cost due to the lack of competitive pressure and the
incentive to overstate cost to regulators.Cost Cedeclines over
time T.

Profit pe is income less
expense, and the following profit function focuses on the effect of regulation
R on profit,

The estimate of (8) is also in Table 4.A higher price of electricity Pe raised profit pe, and by about the same
percentage.Input prices Pg,
Pc, and Po have no effect on profit pe, suggesting electric
customers paid fuel costs.

Larger firms have
higher profit, every 1% increase in output per firm q resulting in slightly
more than 1% increased profit pe.Firm size q does not affect cost in (7) and
must have stimulated revenue.The consolidation and mergers of restructuring paid dividends.

Increased percentage
use of steam plants G lowered profit pe slightly even though
costs in (7) are not affected.Firms
were evidently not able to raise revenue with the increased use of steam.Increased percentage hydro generation H
raised profit pe in (8) and lowered cost in (7).Over time T, profit pe fell.

The negative
coefficient for regulation R in (8) might suggest that it was successful in
controlling profit pe.Regulated monopolies, however, have the incentive to overstate costs and
report low profit.Combining the results
for R in Tables 4 and 5 indicates that regulation led to higher cost and lower
profit.Higher costs could have been due
to relatively high worker perks, overcapitalization, or inefficiency of the new
state monopolies.

Table 5.Determinants of Profit, pre- and post-1912

lnPe0.978lnPD0.306

(6.89)(1.33)

lnPg-0.012lnPgD-0.064

(-0.18)(-0.47)

lnPc-0.084lnPcD0.207

(-0.49)(0.65)

lnPo0.207lnPoD-0.088

(2.02)(-0.57)

lnq0.980lnqD0.118

(19.4)(1.49)

M-0.721MD0.555

(-3.14)(1.93)

H0.279HD0.392

(1.37)(1.27)

R-0.249RD0.168

(-2.62)(1.19)

To examine the effect
of regulation on profit over time, split the 1907-1922 data into two subsets with
the break at 1912 corresponding roughly to what Jarrell (1978) calls early and
late regulation.Only 18 states had
commissions in 1912 but there were 30 by 1917, and Jarrell uses 1917 as the
break date.A dummy variable D for the
profit function in (8), D = 0 in 1907 or 1912 and D = 1 otherwise, is
interacted with each term in (8) and reported in Table 5.

Price had a strong
effect on profit pe up to 1912.Prices of gas Pg and coal Pc had
no effects on profit pe during either period, evidence electric
customers paid fuel costs regardless of industry structure.Competition ensured lower fuel costs resulted
in to lower electricity prices.

A higher price of oil Po increased profit pe for electricity
producers before 1912, suggesting that electricity and oil were substitutes in
consumption.Output per firm q had a
strong positive effect on profit during the early period, again suggesting that
restructuring paid dividends.

The negative effect of
percentage steam generation G on profit pe occurred before
1912.The new technology was not
profitable during the more competitive era.Competition may have encouraged the new technology but firms were not
able to translate that technology into higher profits.

Increased percentage
hydro generation H, however, raised profit pe during the competitive
early period.Higher profit is
consistent with the lower cost in (7).However, over the entire period in the multi-market model, increased
hydro generation resulted in lower cost and higher electricity prices.Hydro generation was cost effective but
consumers did not benefit over the entire period, perhaps due to monopoly
pricing.

There is a negative
relationship between regulation R and profit pe during the competitive
period up to 1912, but regulation encouraged firms to report lower profit.Firms lobbying for a monopoly franchise would
want to appear unprofitable.The
coefficient of R for the late period is the sum of coefficients of R and
RD:.249 + 0.168 = -0.081.The t-statistic is calculated by the dividing
the coefficient estimate by its standard error [var(G) + var(GD)
+ 2cov(G, GD)]2 = 0.105.The
insignificant t-statistic is -0.762.After 1917, regulation did not affect profit.

7.Conclusion

In the early years of
the US electric industry, a
successful industry lobby led to restructuring from local franchises to state
regulated monopolies.The present study
finds that this first step in restructuring reduced the number of firms,
raised, cost, and raised the price of electricity.Regulation had less effect on profit as the
monopolies matured.The present results
support the theory that the new monopolies captured the regulators.

At present, there is an
opposite move of sorts, from regulated state monopolies toward retail
competition.Reversing the results of
the present study, the implications are more firms, lower cost, and lower
price.There are complicating issues and
historical differences from the earlier restructuring, including lower energy
consumption shares, higher per capita consumption, better
technology, telecommunication, more local pollution, increased awareness of
pollution, highly organized interest groups, increased government involvement
at various levels, and federally regulated interstate wholesale competition.Still, it is safe to say that a move away
from regulated state monopolies toward increased competition will increase the
number of firms, lower costs, and lower prices in the electric industry.

References

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20 (2), 70-83.

Behling, Burton (1938) Competition and Monopoly in Public Utility Industries, Urbana: University of Illinois.

Census
of the Electric Power and Light Industry, Department of Commerce, Bureau of the Census.WashingtonDC: Government Printing Office, various
years.